2. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. N EGOTIABLE I NSTRUMENTS, C REDIT, AND B ANKRUPTCY Chapter 13 Meiners, Ringleb & Edwards The Legal Environment of Business, 12 th Edition

3. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. C HAPTER I SSUES Negotiable Instruments Credit Bankruptcy

4. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. N EGOTIABLE I NSTRUMENTS Functions of Negotiable Instruments Substitute for cash (checks for example) Provides way to extend credit (promissory note) Types of Negotiable Instruments 3 party instruments used instead of cash and as credit device Orders to Pay: Drafts Orders to Pay: Checks 2 party instruments used as credit device Promises to Pay: Notes Promises to Pay: Certificates of Deposit

5. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. T HE C ONCEPT OF N EGOTIABILITY Can be transferred to another party Assigned - Assignee has same rights and responsibilities as assignor Transferred by negotiation - Transferee takes instruments free of transferors responsibilities Transfer order instrument by: Payee endorses and Delivers instrument to third party Bearer instruments Drawer my create to bearer; to the order of bearer, payable to bearer, to cash or pay to the order of cash Risky – if lost, can be cashed by finder Transfer bearer instrument by delivery

6. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. R EQUIREMENTS FOR N EGOTIABLE I NSTRUMENTS Only negotiable instruments fall under the UCC If nonnegotiable, the common law applies To be negotiable it must: Be written Be an unconditional order or promise to pay Be signed by the maker or drawer Be payable on demand or at a specified time Be made out payable to order (order paper) or to bearer (bearer paper) Must state a certain sum of money

7. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. R EQUIREMENTS FOR H OLDERS IN D UE C OURSE Person in possession of negotiable instrument may be ordinary holder or holder in due course Ordinary holder has same contract responsibilities as assignee – holder in due course does not To be holder in due course, transferee must: Give value for instrument Take instrument without knowledge it is overdue or defective Take instrument in good faith

8. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. I NTERNATIONAL P ERSPECTIVE I NTERNATIONAL P ERSPECTIVE MIXING RELIGION AND FINANCE In U.S. laws limiting high interest rates (usury) can be traced to Christian views that the practice is sinful. Islamic limits on interest are even more stringent. Some Islamic countries prohibit banking as usual, such as charging interest on loans & paying interest to depositors. Many believers in the Koran hold this to be haram or banned by Islam. In Malaysia and other countries, banks consult with advisers on Shariah (Islamic law) about what forms of loans and repayments are acceptable. Modern financial instruments are now more widely available – but the presentation is different. (Continued)

9. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Example: Conventional finance company may borrow $100 million and pay 6% ($6 million/year) on 10-year note. Then repay principal. Under rules permitted (halal) by some Islamists, the borrowing company transfers assets, like buildings to a legal entity like a trust (ijara sukuk). Company leases assets back for payments of $6 million/year. Borrower also pledges to buy back assets at the end of 10 years for $100 million. Not all Islamists agree this is acceptable. However, many banks using this method have seen explosion of growth. I NTERNATIONAL P ERSPECTIVE I NTERNATIONAL P ERSPECTIVE MIXING RELIGION AND FINANCE

10. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. M AJOR T YPES OF N EGOTIABLE I NSTRUMENTS Drafts o Unconditional written promise to pay Drawer orders drawee to pay $$ to payee Time draft says at a specified time Sight draft gets paid upon presentation o Sales draft – for sale of goods o In international, called a bill of exchange o Bankers acceptance creates a guarantee by a bank that draft is good. Checks o Draft drawn on a bank and payable on demand o Checks used to be a major method of payment o Now credit & debit cards have largely replaced checks o On a cashiers check the bank is both drawer and drawee o See Exhibit 13.1

11. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. C ASE C ASE A SSOCIATED H OME AND RV S ALES V. B ANK OF B ELEN Plaintiff sells recreation vehicles under trade name Enchantment. Hired Ramos to assist with bookkeeping In 20 months, Ramos forged 211 checks payable to herself or to cash; $283,547 stolen from Enchantment Managers discovered forgeries and notified bank. Bank refused to cover loses Said it sent monthly statement Included photocopies of cancelled checks Enchantment sued Bank of Belen for common law fraud and negligence and for negligence under the UCC. Trial court granted summary judgment to bank. Enchantment appealed. (Continued)

12. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. UCC states that usually common law principles are not preserved in an area which is thoroughly covered by the UCC. Art. 4 of UCC: sets up a liability scheme & defenses between payor-bank and customers A forged or altered check is not properly payable; Bank is strictly liable for resulting losses to its customer UCC 4-406 Bank may seek safe harbor from that strict liability if it makes statements available to the customer. Customer can then ID forgery & must be reasonably prompt in notifying it to bank. This is within 30 days of receiving the statement – then bank is strictly liable for loss. After 30-day period, bank is liable only if customer proved bank failed to exercise ordinary care in passing the forged item and bank substantially contributed to the loss. Loss is then apportioned between customer & bank based on comparative negligence. Regardless, if a year or more has passed since customer receives statement and IDs forgery, customer cannot bring a claim under the UCC – then customer bears the loss. In this case, UCC 4-406 provides scheme for liability and defenses. C ASE C ASE A SSOCIATED H OME AND RV S ALES V. B ANK OF B ELEN

13. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. C ASE C ASE A SSOCIATED H OME AND RV S ALES V. B ANK OF B ELEN HELD: Therefore common law claims by Enchantment are precluded. Enchantment, however, was entitled to try to prove a lack of ordinary care by the Bank within 1 year of Enchantment alerting Bank of the forgeries. If bank sent statements directly to Ramos, an employee, this is a reasonable manner of notification to Enchantment. HELD: Summary Judgment reversed re: UCC negligence issue. Enchantment did minimum necessary to raise issues of fact that jury may view. Jury can then determine whether Bank breached its duty of ordinary care to Enchantment.

14. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. P ROMISES TO P AY P ROMISES TO P AY Notes Promise by the maker to pay certain $ to payee Usually called promissory notes But also have Collateral note Real estate mortgage note Installment note Balloon note See Exhibit 13.2 Certificates of Deposit Bank is maker of certificate & promises to repay customer payee Most large certificates are negotiable which allows them to be sold, used to pay debts or used as collateral

15. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Creditor: Lends money Debtor: To whom money is lent Principal: The sum of the debt owed Equity financing: Sale of stock in company or sale of negotiable instruments subject to securities regulation Debt financing: Borrowing money evidenced by contract Credit Policy focuses on characteristics such as: Capacity (the debtors ability to pay) Capital (the debtors financial condition) Character (the debtors reputation) Collateral (the debtors assets to secure the debt) Conditions (the economic situation affecting the debtors business) C REDIT

16. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. C REDIT A CCOUNTS Open Account Must pay within fixed time period Installment Account Repay through regular (usually monthly) payments Revolving Account Make minimum payment & can add new debt – i.e. credit card See Exhibit 13.4

17. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. C OLLECTIONS P OLICY Needed for debtors who fail to make timely payments Starts with a past-due letter Followed by telephone call or 2 nd letter Letters may be followed by a personal visit. Additional action may be necessary – depends on whether a creditor is unsecured or secured. If debtor is insolvent, creditor will receive nothing.

18. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. C REDIT WITH S ECURITY When creditor can take property of debtor to satisfy debt – can happen by agreement or by operation of law By Agreement - Depends if property is real or personal Suretyship - Promise by a third party to pay debt if debtor doesnt Guarantor – Provides a guarantee of payment to creditor should principal debtor fail to pay Defenses of Sureties - Since debt falls under contract law, there are the same defenses that the principal (debtor) has – including, impossibility, illegality, duress, fraud Suretys Rights Against the Principal If borrower could pay creditor but refuses to, surety is entitled to exoneration (court order for principal to pay) Subrogation – Surety is entitled to rights of the creditor against the debtor

19. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. C ASE C ASE GE B USINESS F INANCIAL S ERVICES V. S ILVERMAN Warren Park Partners, Ltd. borrowed $34.8 million from GE Financial. Bought land in Frisco, Texas. When loan was made, Silverman & partners signed a guaranty absolutely, unconditionally guaranteeing full payment. Warren Park defaulted; went into bankruptcy. GE demanded payment from Silverman. Silverman didnt pay; GE sued. Silverman & parties claimed affirmative defenses of (1) fraud, (2) extortion, (3) theft & (4) economic duress. Said hours before signing the documents, GE notified them changes in terms of the agreement. They had no time to contest, as loan was needed immediately. He signed agreement because he was trapped. Claimed GE employee told him new terms would not be enforced. GE moved for summary judgment. (Continued)

20. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. HELD: Summary judgment for GE. GE offered evidence of both claims that defendants did not contest. Instead defendants asserted the 4 affirmative defenses (above). GE argued even if affirmative defenses are true, allegations are barred by the Credit Agreement Act (ICAA). ICAA bars all actions or defenses by a debtor based on an oral agreement (similar to Statute of Frauds). Defendants didnt dispute that they made credit agreements. Defendants say ICAA does not bar their affirmative defenses. They also argue unclean hands of the plaintiff, GE. The court was not swayed, because – Oral promises by GE contradict the terms of Counts I and II; therefore the ICAA bars defendants affirmative defenses. Silverman loses. C ASE C ASE GE B USINESS F INANCIAL S ERVICES V. S ILVERMAN

21. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. S ECURED T RANSACTIONS Product may secure debt Commercial sale of goods - UCC Article 9 (not real estate) Must create security interest - be sure it is: 1. Attached (Attachment) Signed by customer Seller provided value Customer has legal, transferable rights in collateral 2. Perfected (Perfection) Filing w/proper official Interests in Inventory As collateral, equipment, inventory, raw materials (tangible property) are used as security Floating Lien Inventory Goods held for sale as well as raw materials Inventory is constantly changing

22. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. D EFAULT BY D EBTOR Some property my be exempt, i.e. homestead exemption (when personal assets have been placed as collateral Default is when the buyer doesnt repay Creditor can take back property and keep or may resell it (in a commercially reasonable manner) Any excess from sale of repossessed property over debt owed must be returned to debtor See Fordyce Bank & Trust Co. v. Bean Timberland, Inc. See Exhibit 13.5

23. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. C ASE C ASE F ORDYCE B ANK & T RUST V. B EAN T IMBERLAND, I NC. Fordyce Bank made series of loans to Bean Timberland so it could buy timber from landowners. Bean would cut timber and sell logs to Potlatch and Idaho Timber (P&I) – it would then mill logs into timber. Beans proceeds from timber sales would repay loans. Bank perfected its interest by filing UCC Financing Statement with the Secretary of States Office of Arkansas. Bean sold timber but failed to repay loans; went bankrupt. Bank sued P&I because it had a priority interest in the timber sale proceeds. Bank said P&I was negligent in its dealings for failing to do a lien search and did not exercise good faith required under the UCC. Trial court held for P&I, ruling they were not negligent. Trial court said that P&I was not required to perform a security interest search in the ordinary course of business. The bank appealed. (Continued)

24. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Under Arkansas UCC 4-9-320, a buyer in the ordinary course of business (P&I) takes free of a security interest created by the buyers seller [Bean], even if the security interest is perfected [by the bank] and buyer knows of its existence. If P&I were buyers in ordinary course of business, they had no duty to perform a lien search. Even if they know of banks security interest, P&I can take free of Banks security interest. HELD: Affirmed. P&I won. Clear evidence that purchasing gatewood (lumber brought to the mills front gate, and if meets mills specs, then mill purchases it) without performing a lien search is standard timber industry practice. P&Is actions were usual or customary practices in the timber industry, and they were therefore buyers in the ordinary course of business. Owed no duty to the bank to conduct a lien search. C ASE C ASE F ORDYCE B ANK & T RUST V. B EAN T IMBERLAND, I NC.

25. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. R EAL E STATE F INANCING Mortgage: Real estate is used to secure a debt obligation evidence by a mortgage Debtor is the mortgagor Creditor is the mortgagee Mortgage is a lien in most states In case of default, the mortgagee has the right to foreclose on property Deficiency judgment: If proceeds from foreclosure not sufficient, a separate legal action against debtor is maintained Most mortgages are non-recourse debt – Lender can seize collateral/property but not seek a deficiency judgment for money owed not covered by sale of property Statutory redemption: Period of time mortgagor has the right to redeem the property by paying the debt (normally within 6 months after default) Most states have this procedure

26. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. L IENS Nonconsensual lien Obtained by Operation of Law No Need for Debtors Consent Procedures of using liens under state statutes; Must be removed before property is sold Mechanics Lien Party that furnished material, labor, or services for construction or repair of building or other real property places the lien Possessory or Artisans Lien Party that added value to or cared for personal property puts on lien Court-Decreed Liens Attachment lien is court-ordered seizure of goods through writ of attachment Judgment lien occurs when creditor has successful action against debtor; If debtor doesnt pay judgment, creditor asks court for writ of execution

27. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. C ASE C ASE S UMMERS G ROUP, I NC. V. T EMPE M ECHANICAL, LLC Summers Group d/b/a Rexel, sold electrical materials for construction on property owned by Metro Lofts. Rexel was not paid on June 26, 2008 and recorded a mechanics lien on Metro Lots property. Other contractors on the work including Tempe Mechanical, also filed liens against Metro Loft. No payment received – Rexel brought suit on December 24, 2008 against Metro Lots and all other lienholders. Some of lienholders (contractors) did not respond – had default judgments. Tempe, answered Rexels complaint Metro was in bankruptcy & under control of bankruptcy trustee ML Manager. All parties agreed bankruptcy court would determine priority of payment of liens. ML Manager argued that it stood first to receive payment, since it should not be challenged and that Rexel should pay all attorney fees related to litigation. Trial Court agreed. Rexel appealed. (Continued)

28. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Arizona law establishes lien procedures, including naming of all other mechanics lien claimants if those others fail to file a lien themselves. Remaining Lien Claimants asserted their lien priorities. The bankruptcy courts decision also affected their claims. Therefore ML Manager had to defend its lien priority. Statute requires that when sale is ordered in mechanics lien foreclosure action, proceeds are prorated over all lienholders that have equal footing with the foreclosing lien. Attorneys fees are apportioned between successful and unsuccessful efforts. HELD: Reversed and Remanded. Trial court erred in holding Rexel solely responsible for payment of ML Managers attorney fees. These fees should be prorated among lien claimants. Intent of statute is to create an even playing field for all who provided services and materials, regardless of date work was performed. All Remaining Lien Claimants will be liable for ML Managers attorney fees in proportion to their claims. C ASE C ASE S UMMERS G ROUP, I NC. V. T EMPE M ECHANICAL, LLC

29. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Purpose: Orderly resolution where debtor owes more than can be paid. Federal Bankruptcy Code has been amended – most recent revision was The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. Most bankruptcies involve individuals. A person must take credit counseling before filing bankruptcy. After filing bankruptcy, there must be debtor education about budgeting, use of credit, etc. Key feature: fair treatment of creditors B ANKRUPTCY

30. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. P ERSONAL B ANKRUPTCY Most bankruptcies involve individuals. Creditors usually do not get paid. Before filing, person must complete a debtor education course. Dept. of Justices U.S. Trustee Program approves organization s to provide mandatory credit counseling & debtor education. Credit counseling is taken before filing bankruptcy. Debtor education is taken after filing. Income and Means Testing Income test determines if person files under Chapter 7 (liquidation) or Chapter 13 (reorganization of debts). People with higher income less likely to have debts extinguished. There is a test of income against expenditures – to see if person is living above average for a given income level.

31. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. C HAPTER 7 Most bankruptcies are voluntary, but creditors may force an involuntary proceeding. Some assets, such as car, clothing, appliances, some home equity and pension are exempt. Upon filing, there is a freeze on actions against the debtor and the debtors property. Trustee is appointed to administer the debtors estate. Assets are liquidated and proceeds distributed to creditors. After discharge, debtor is not liable for debts covered by proceeding. Liquidation and fair distribution of debtors non-exempt assets to creditors.

32. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. C HAPTER 13 Available only to individuals; only voluntary option. Sole proprietorship owned by an individual may file under Chapter 13. Debtor files plan for payment of creditors over time. Usually over 5 years. Debtor keeps property and shares administration of the bankrupt estate with court-appointed trustee. Trustee makes sure payments are made and that creditors dont try to go around fixed payment schedule. Court protected debt repayment plan. Confirmation Plan that was approved makes these payments. Debts of those bankrupt not discharged. Long-term secured debt (i.e. house mortgage) treated differently. IF plan fails, possible to shift to Chapter 7 for hardship discharge.

33. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. P RIORITY C LASSES OF C REDITORS Secured creditors Costs of preserving and administering debtors estate Unpaid wage claims Certain claims of farmers and fishermen Refund of security deposits Alimony and child support Taxes Unsecured creditors All creditors of a particular class must be paid before going to next class

34. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. C ASE C ASE I N RE D ARBY After Darby filed Chapter 13 bankruptcy, Time Warner canceled cable service. Darby filed motion with bankruptcy court to compel Time Warner to reinstate his service, with his assurances of future payment. Bankruptcy Court and District Court ruled that cable service was not a utility that must be provided as a necessity under law. Darby appealed. HELD: Affirmed. Cable service is not a necessity. Bankruptcy laws give protections to debtors from cut-off of service by a utility after they file for bankruptcy. Utilities are necessities and must be provided to debtors. Includes electric company, gas supplier or telephone company that is a monopoly in the area. Cable service is not a necessity, and bankruptcy court need not require its reinstatement to Darby.

35. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. C HAPTER 11 Allows businesses to keep operating, without liquidation of assets Prepackaged bankruptcy filings: debtor & creditors settle issues before debtor files, and court then approves Reorganization Stays further action by creditors Debtor acts as trustee, called debtor in possession, to run business for benefit of all parties Creditors are satisfied by class in order of priority of claims

36. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. C ASE C ASE I N THE M ATTER OF K MART C ORPORATION Kmart consists of parent company and 37 affiliates and subsidiaries. Kmart, requested to pay, in full, claims of critical vendors. Kmart said that if it didnt pay these vendors, they would not do business in the future and were necessary for Kmart to stay in operation. Bankruptcy judge agreed – granted order. No notice to disfavored creditors. Kmart determined the critical vendors, paying 2330 suppliers $300 million. Other 2000 vendors not paid, and 43,000 additional unsecured creditors received 10 cents on the dollar (mostly in stock of reorganized company). (Continued)

37. ©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Some of creditors appealed. District court reversed order of payments to critical vendors. Decision was appealed. HELD: Affirmed. Kmart argued that the District Courts reversal order was too late – money had already changed hands. To order payment of critical vendors, it is necessary to show (1) Disfavored creditors will be as well off with reorganization as with liquidation (this was never demonstrated), and (2) That critical vendors would cease deliveries if old debts were left unpaid during litigation. This was not always true, i.e. some of the critical vendors must continue business due to have long- term contracts C ASE C ASE I N THE M ATTER OF K MART C ORPORATION